Consider the following two, completely separate, economies. The expected return and volatility of all stocks in both economies is the same. In the first economy, all stocks move

togetherin

good times all prices go up together and in bad times they all fall together. In the second economy, stock returns are

independentone

stock increasing in price has no effect on the prices of other stocks. Assuming you are risk-averse and you could choose one of the two economies in which to invest, which one would you choose? Explain.

a)

A risk-averse investor would prefer the economy in which stock returns are independent because by combining the stocks into a portfolio he or she can get a higher expected return than in the economy in which all stocks move together.

B.

A risk-averse investor would choose the economy in which stocks move together because the uncertainty is much more predictable, and you have to predict only one thing.

C.

A risk-averse investor is indifferent in both cases because he or she faces unpredictable risk.

D.

A risk-averse investor would choose the economy in which stock returns are independent because risk can be diversified away in a large portfolio.